In Brief

In November 2013, the U.S. District Court for the Western District of Wisconsin ruled that the parsonage allowance of IRC section 107(2) was unconstitutional under the Establishment Clause of the First Amendment. In November 2014, the Seventh Circuit Federal Court of Appeals overturned this judgment and ruled that the plaintiffs did not have standing to argue the unconstitutionality of the parsonage allowance. This article discusses the ramifications of the case, noting that while the parson-age allowance remains constitutional, its merits are still in question. The author also discusses broader implications regarding standing and the importance of pursuing administrative remedies prior to litigation.

In November 2013, the U.S. District Court for the Western District of Wisconsin ruled that the parsonage allowance under Internal Revenue Code (IRC) section 107(2)—an exclusion from income for employer-paid housing to ministers—was unconstitutional. The court held that the exclusion violated the First Amendment’s Establishment Clause because it advanced religion. In November 2014, the Seventh Circuit Federal Court of Appeals overturned the lower court’s judgment, finding that the plaintiffs did not have standing before the courts to argue the unconstitutionality of the law. The Seventh Circuit vacated the lower court’s ruling, effectively preserving the constitutionality of the parsonage allowance.

The discussion below analyzes this case, the arguments concerning the constitutional merits of the parsonage allowance, and the application of the legal doctrine of standing in litigation. It concludes by offering practical implications of the Seventh Circuit’s ruling for ministers and their tax advisors.

Gross Income Exclusion for Ministers

Under IRC section 61, both monetary and nonmonetary benefits that an employee receives from an employer are included in the employee’s gross income and subject to tax, unless the value of the benefit is specifically excluded from gross income under the IRC. In 1921, Congress passed IRC section 107(1), which grants ministers an income tax exclusion from gross income for the value of a residence they receive in-kind from an employer. Although the legislative history is bare, Congress presumably passed the exclusion due to the historical practice of not taxing churches and to avoid entanglement between government tax collectors and church ministers.

In 1954, Congress broadened the exclusion to also exclude from a minister’s gross income any allowance that was paid to the minister for housing. The legislative history notes that Congress apparently wanted to avoid discrimination between congregations that could only afford to pay ministers cash allowances for their housing and wealthier congregations that could afford the higher capital costs inherent in providing in-kind housing to their ministers. This “parsonage allowance” exemption is found in IRC section 107(2).

The Freedom From Religion Foundation Case

Freedom From Religion Foundation Inc. (FFRF) is a nonprofit membership organization of atheists and agnostics, with more than 17,000 members, that advocates for the separation of church and state. Copresidents of FFRF have included Dan Barker, a former ordained minister, and Annie Laurie Gaylor, daughter of the foundation’s founder and wife of Barker. In 2011, FFRF began paying Barker and Gaylor a housing allowance. Neither Baker nor Gaylor excluded their allowance payments on their federal income tax returns or filed a claim for refund after payment; however, in September 2011, FFRF, Barker, and Gaylor filed a complaint with the U.S. District Court for the Western District of Wisconsin, arguing that paragraphs 1 and 2 of IRC section 107 were unconstitutional as a violation of the Establishment Clause. The plaintiffs later amended their complaint to argue that only the IRC section 107(2) parsonage allowance was unconstitutional; IRC section 107(1) did not apply to them because neither Barker nor Gaylor had ever received in-kind housing from FFRF.

FFRF in the District Court

At the district court level, the plaintiffs made arguments on both the issue of standing (i.e., why the plaintiffs had a right to be heard by the courts) and the merits of the case (i.e., why the parsonage allowance was unconstitutional). The plaintiffs maintained that they had standing to sue because they met the proper requirement of showing an injury that could be remedied by the courts. The plaintiffs argued that because they were denied a benefit conditioned on religious affiliation, they had received an injury, and that the court could provide a remedy by striking down the statute that created the injury. The IRS argued that because the plaintiffs never tried to claim the exemption through administrative processes with the IRS, the lawsuit was premature and therefore lacked standing.

The district court found that the plaintiffs had standing to sue because the plaintiffs’ injury was clear from the statute—specifically, that the plaintiffs were excluded from a tax exemption granted to others. Once the court decided the procedural requirements of standing were met, it reviewed the merits of the case.

The district court’s ruling on the merits.

The Establishment and Free Exercise Clauses of the First Amendment state consecutively that, “Congress shall make no law respecting an establishment of religion, or prohibiting the free exercise thereof.” Generally interpreted, the Establishment Clause prohibits Congress from inappropriately advancing religion, and the Free Exercise Clause prohibits Congress from interfering with religious practices and institutions.

The district court found that the parsonage allowance violated the Establishment Clause. The district court invoked the test from Lemon v. Kurtzman [403 U.S. 602 (1971)], which is the Supreme Court’s preferred precedent concerning whether a law or other government action is constitutional under the Establishment Clause. Under the Lemon test, the parsonage allowance would violate the Establishment Clause if 1) it had no secular purpose, 2) its primary effect advanced or inhibited religion, or 3) it fostered an excessive entanglement with religion.

Under the first prong, FFRF argued that the parsonage allowance did not have a secular purpose because it was not available to secular taxpayers (and was therefore discriminatory). Alternatively, FFRF argued that under the second prong, the government had advanced religion because religion was being provided a preferential benefit. The IRS argued that the government’s primary purpose in enacting the parsonage allowance was not to advance religion, but instead to eliminate discrimination between those ministers who received housing in-kind and those ministers who only received allowances.

The IRS further reminded the court that total separation between church and state is not possible and that some relationship between the government and religious organizations is inevitable. The IRS noted that in Walz v. Tax Commission of the City of New York, the U.S. Supreme Court upheld a property tax exemption allowed for both churches and nonprofit organizations. The court in Walz stated that the “legislative purpose of a property tax exemption is neither the advancement nor the inhibition of religion,” and is therefore “neither sponsorship nor hostility … The grant of a tax exemption is not sponsorship since the government does not transfer part of its revenue to churches but simply abstains from demanding that the church support the state” [397 U.S. 664, 672, 675 (1970)].

The district court distinguished Walz from FFRF’s facts, stating that the former dealt with a broad tax exemption that included nonprofit organizations as well as churches; FFRF, on the other hand, was arguing against a tax exemption that only applied to religious persons.

The IRS argued that because the plaintiffs never tried to claim the exemption through administrative processes with the IRS, the lawsuit was premature and therefore lacked standing.

Ruling for FFRF, the district court followed the reasoning in Texas Monthly Inc. v. Bullock [489 U.S. 1 (1989)], which held that when the government gives a subsidy—for example, a tax exclusion—exclusively to religious organizations, such a subsidy conveys a message of endorsement of religion, which therefore has a primary effect of advancing religion, thus violating the Establishment Clause under the second prong of the Lemon test. The court held that because the parsonage allowance conveyed a message of endorsing religion, it violated the Establishment Clause and was unconstitutional. The district court delayed striking down the statute until the parties could exhaust their judicial appeals, and the IRS appealed the case to the Seventh Circuit.

FFRF in the Appellate Court

Twelve months after the district court’s ruling that the parsonage allowance was unconstitutional, the Seventh Circuit—finding that FFRF and its copresidents lacked proper standing to sue in the first place—vacated the lower ruling and directed the district court to dismiss the case. In reaching its conclusion, the Seventh Circuit applied the requirements of standing found in Lujan v. Defenders of Wildlife [504 U.S. 555, 560 (1992)]: the plaintiff must show that he has suffered 1) a concrete and particularized “injury in fact” 2) that is fairly traceable to the challenged action of the defendant and 3) that is likely to be redressed by a favorable judicial decision. The circuit court’s analysis focused on the injury requirement and started with the premise that, as stated in Lujan, a “generally available grievance about government” could not be considered an “injury” for deciding standing. The Seventh Circuit identified three potential avenues for standing in an Establishment Clause case:

Direct harm.

First, any direct harm by the establishment of religion would provide a plaintiff standing to challenge the parsonage allowance statute. Court case examples of direct harm have included mandatory prayer in a public school classroom or being exposed to religious symbols. The courts have been clear, however, “that a plaintiff cannot establish standing based solely on being offended … psychic injury alone is insufficient.” The court ruled that the plaintiffs did not suffer direct harm from the parsonage allowance because the exclusion “does not require them to see or do anything.”

The Flast rule.

The second avenue for standing in an Establishment Clause case is known as the Flast rule [Flast v. Cohen, 392 U.S. 83 (1968)]. Generally, the challenge of a government expenditure may not be solely based on the plaintiff’s taxpayer status. If courts granted standing to sue the government merely because the plaintiff was a taxpayer, the courts would be overrun with taxpayers suing the government anytime they disagreed with how the government spends money. Flast, however, allows objecting taxpayers to have standing to sue the government in narrow cases where tax expenditures are specific government appropriations in “derogation” of the Establishment Clause. An example would include government funds being paid directly to a church—such a direct payment would so clearly advance religion using a taxpayer’s tax dollars that Flast allows any taxpayer to have standing in those narrow cases. But under FFRF’s facts, because the parsonage allowance is not a specific government appropriation, the court found that the Flast rationale for standing did not apply to the plaintiffs.

The FFRF suit put the IRS in the curious position of having to defend a tax exemption’s constitutionality—a loss by the IRS would have meant increased revenue for the treasury.

Dollars-and-cents injury.

The final avenue offered by the Seventh Circuit was for the plaintiffs “to demonstrate that ‘they have incurred a cost or been denied a benefit on account of their religion … such as when the availability of a tax exemption is conditioned on religious affiliation.’ This approach … bases standing on the allegation that the government’s unconstitutional action caused the plaintiff a concrete, dollars-and-cents injury.” The court noted that although the plaintiffs argued that they had standing “because they were denied a benefit (a tax exemption) … that is conditioned on religious affiliation,” the plaintiffs’ argument failed “for a simple reason: the plaintiffs were never denied the parsonage exemption because they never asked for it.”

The court ruled that a taxpayer “cannot establish standing to challenge [an exemption] without having personally claimed and been denied the exemption.” Since FFRF’s plaintiffs never excluded the income on their tax returns, they had never legally claimed the benefit; because they never claimed the benefit, the government never denied it.

The court further noted:

Allowing members of discriminatedagainst groups who have not suffered a particularized injury to bring suit would not only be unconstitutional, it would also create practical difficulties by opening the door to constitutional challenges to any tax exemption that a given individual suspects he may not be entitled to—without first giving the IRS and the Tax Court the opportunity to determine the proper construction and application of the law.

In other words, because the taxpayers did not respect the administrative processes of the law, which required the exhaustion of administrative remedies with the IRS, the court, an adjudicator of last resort, was not willing to hear the merits of the plaintiffs’ case.

The Seventh Circuit further sharpened the importance of exhausting administrative remedies by addressing the district court’s error in ignoring those remedies. The circuit court stated:

Requiring the plaintiffs to formally request the parsonage exemption, the district court said, would be a “waste” of “time” and would be “unnecessary busy work”. … The constitution does not allow federal courts to hear suits filed by plaintiffs who lack standing. … [Standing] is not merely a troublesome hurdle to be overcome if possible so as to reach the “merits” of a lawsuit which a party desires to have adjudicated; it is a part of the basic charter promulgated by the framers.

In its judgment, the Seventh Circuit reinforced the significance of the procedural requirement of standing, highlighted the necessity for taxpayers to exhaust administrative remedies with the IRS in tax cases, and, incidentally, preserved the constitutionality of the parsonage allowance.

Implications for Ministers and Tax Professionals

For ministers and their advisors, IRC section 107 exclusions for in-kind housing and allowances paid for housing remain constitutional and allowed by the IRS. The courts have, however, left the door open for future constitutional challenges over both types of exclusions. The Seventh Circuit did not directly refute the merits of the lower court’s ruling that the parsonage allowance violated the Establishment Clause, and it actually provided a narrow road map of how a constitutional challenge to the parsonage allowance could satisfy the standing requirements—challenging parties need only to exhaust their administrative remedies with the IRS to show an injury and achieve standing.

It should be noted that although future litigants may find standing in this area, courts weighing the merits of a constitutional challenge will again assess the IRS’s arguments that the minister exclusions are constitutional. Such arguments contend that historical and practical accommodations to religion do not necessarily advance religion and are instead accepted under the Free Exercise Clause. It is likely that future courts will be cautious before disposing of a tax benefit so extensively relied on by ministers and the churches they serve.

Implications of the case for tax professionals include the importance of understanding the judicial doctrine of standing, the importance of exhausting administrative remedies, an understanding of the IRS’s role in protecting tax law, and the likelihood that this area of the IRC will see increased litigation in the future.

If standing requirements are not met, the courts will not hear the merits of a client’s case. In order for a taxpayer to be heard, the taxpayer must show a specific injury. Generally this is not a problem for taxpayers, especially in areas where the IRS has assessed a deficiency; however, taxpayers are not in a position to indiscriminately challenge a tax statute or rule without meeting this requirement.

Courts hold themselves as authorities of last resort. Part of this approach is to acknowledge the constitutional checks and balances on the power of the courts; the power to interpret the law and be the final word is great, and therefore the cases that can be heard should be limited. Part of this last-resort approach is also due to practical concerns; the courts do not want to be overwhelmed by parties who already have an avenue to resolve their differences through administrative remedies. Because of this, courts will not hear taxpayers who have not exhausted their administrative remedies with the IRS.

The IRS has an obligation to protect all revenue laws, whether such laws increase or decrease government revenue. The FFRF suit put the IRS in the curious position of having to defend a tax exemption’s constitutionality—a loss by the IRS would have meant increased revenue for the treasury.

Ultimately, the tax profession can anticipate increased litigation in the near future regarding tax provisions with religious overtones. Such litigation will continue as long as the federal courts grapple to strike a balance between allowing government accommodation of the free exercise of religion while constraining government promotion of religion in a manner that violates the Establishment Clause.

William A. Bailey, JD, LLM, CPA is an assistant professor in the master’s of taxation program at the school of accounting and taxation, Weber State University, Ogden, Utah.